India's Dilemmas: The Political Economy of Policymaking in a Globalised World

SPECIAL ARTICLEEconomic & Political Weekly february 2, 200853India’s Dilemmas: The Political Economy of Policymaking in a Globalised WorldKaushik BasuThis paper is a revised version of the First Sage-Madras School of Economics Endowment Lecture, delivered by the author on December14, 2007 in Chennai. The author is grateful to Raja Chelliah for his comments following the lecture, and to the audience for the lively discussion and many suggestions to the author. Not for nothing have we earned the epithet “argumentative”. The paper also greatly benefited from helpful criticisms and suggestions by S Subramanian.Kaushik Basu (kb40@cornell.edu) is at the department of economics and with the Center for Analytical Economics, Cornell University, US.The performance of the Indian economy, as measured by the growth rate of aggregate income, has been remarkable, both in terms of past performance and in comparison to other nations. Among the several factors behind this, two which stand out are the economic reforms of the early 1990s and the sharp increase in the savings rate following bank nationalisation in 1969. This outstanding aggregate growth, however, comes with growing inequality and (declining but still) unacceptably high poverty. It is argued that this is partly a consequence of globalisation and gives rise to novel policy dilemmas. The need is for multi-country coordination of policies of a kind that has little precedence. India should use its improving global standing to initiate such an international effort.The Indian economy is in an age of the present continuous. This is evident from a spate of recent titles: India Arriving (Rafiq Dossani), Propelling India (2 volumes, Arvind Virmani), India: Emerging Power (Stephen Cohen), India Globalising (paper, present author). If India does not arrive, emerge or get propelled, there will evidently be a lot of disappointed authors. What are the chances that these same verbs will apply to India in the not too distant a future, but in the past tense? This is a convenient question with which to begin this enquiry. And to get to that we must start with the facts.1 Present Continuous to Simple PastThat the aggregate Indian economy is growing very rapidly is now beyond question. Having grown at around 1 per cent per annum from 1900 to 1950, and at a sluggish 3.5 per cent through the 1950s and 1960s, India’s growth rate suddenly picked up in the late 1970s. From 1993 the economy was growing even faster. Powered by the services sector [Chanda 2007; Basu and Maertens 2007], it seemed to be on a growth path of 6 per cent per annum; and, over the last four years, the growth has been an astonishing 9 per cent. This is clearly a remarkable performance compared to India’s past, but how does it compare with other nations of the world? The answer is, very well; and this can be illustrated by creating a league table of nations in terms of per capita incomes. For this let us go back to 1975, the time when purchasing power parity(ppp)-corrected international data became widely available. If we take the 109 nations for which consistent data are available and track India’s movement through this chart, one can immediately see how the Indian economy has performed vis-à-vis other nations. One hundred and nine nations are, however, difficult to display on a page, so let me consider the poorest 52 nations among them. The rankings are presented in Table 1 (p 54). In 1975 India had a rank of 90 among the 109 nations. In other words it was the 90th poorest nation. There were only 19 nations behind it. By 1984 it had a rank of 89, a small improvement. By 1994 it had moved up to rank 80, and by 2004 to rank 75. This is good performance but it is sobering to see China climbing from the 108th rank to the 58th over the same period.Indeed, if we take the last decade and a half and do a global cross-country comparison, there turn out to be two nations in the world that had consistently higher growth than India. These are China by a wide margin, and Vietnam by a sliver. Pakistan, it is interesting to note, grew faster than India between 1975 and 1984, but after that it fell behind. During this entire period, much

SPECIAL ARTICLEfebruary 2, 2008 Economic & Political Weekly54of south Asia, even with India excluded, has performed better than the global average [Basu and Maertens 2007a].Just as the superior performance of the aggregate Indian economy is now beyond question, equally beyond question is the fact that inequality in India, no matter how one measures it, is growing.1 The outstanding average figures for GDP and growth are being achieved largely by a small segment of the well-off population growing at phenomenal rates, the middle income group growing well but less rapidly and a bottom segment of around 20 per cent of the nation growing at snail’s pace. What this suggests about poverty is true. Poverty, as measured by the percentage of people below the poverty line, is declining but at a rate that is unacceptably low. It is unpardon-able that an economy that is doing so well overall has somewhere between 220 and 280 million people living below the poverty line. And it is important to remem-ber that we draw our poverty line really low, which is a useful technique for keeping these numbers low.I will return to the question of inequality and poverty later; let me for now persist with the question of the prospects of overall growth. To understand this we need to know the sources of India’s rapid growth. Though ideologues will disagree, a dispassionate analysis shows, not surprisingly, that many factors lie behind this. One indicator of the multiplicity of causes is the fact that the economy has reached its current phase of high growth in several steps and with different factors of propulsion behind each one. The question of when the first break in growth in independent India occurred has exercised many minds and as research has progressed we have gone further and further back: early 1990s, early 1980s and even late 1970s [Rodrik and Subramanian 2004; Panagar-iya 2004; Balakrishnan and Parameswaran 2007; Basu and Maertens 2007; Sen 2007]. I would argue that the first of the growth spurts occurred in the year that most of us Indians block out from our psyche as non-existent – 1975. In that first year of the Emergency the nation grew at 9 per cent and it was not just a one-year spurt. Barring a severe downturn in 1979-80, when the economy shrank by 5.2 per cent (the worst year in the history of independent India), the economy never looked back after 1975. What caused this initial breaka-way from stagnation is a matter of some debate, but one undeniable factor is that India’s savings and investment rates had risen sharply from the late 1960s to the late 1970s. What caused this? Clearly, the nationalisation of banks in 1969, with the state-owned banks being forced thereafter to open branches in remote areas of India, and the start of Unit Trust of India in 1964 were key factors in boost-ing the savings rate, which, in turn, was the first impetus for rapid growth. Data on the number of bank branches [Basu and Maertens 2007] show a sharp rise after 1969, suggesting that the government’s directive was actually carried out. The next step up in growth occurred in 1993 and the cause here was very different. The reforms of 1991-93, which led to the removal of India’s notorious licensing system, and initiated a range of policy measures in the international sector, were arguably the most important policy event in India since 1947, and one can see its impact in the faster growth and the exponential build-up of foreign exchange reserves that happened subsequently.2 This is evident from Table 2 (p 55). From 1977 to 1990 our foreign exchange reser-ves hovered around $ 5 billion, occasionally dropping to a precari-ous low level and more occasion-ally crossing $ 6 billion. From 1993 the reserves started rising, steadily and on a high gradient, and are now well over $ 200 billion. The reforms of the early 1990s were primarily concerned with India’s international sector and the success which India saw after that occurred primarily in the nation’s inter-national dealings.3 Not only did the reserves build up, but the Table 1: Bottom 58 Countries GDP Per Capita (PPP, 2000 international $)Rank 1975 1984 1994 200458 Paraguay Dominican Republic Dominican Republic China59 Tunisia Philippines Swaziland Peru60 DominicanRepublicBotswana Peru Swaziland61 Guatemala El Salvador El Salvador El Salvador62 Swaziland Guatemala Jordan Paraguay63 Malaysia Ecuador Jamaica Jordan64 Ecuador Jamaica Philippines Philippines65 Belize StVinc/GrenadinesGuyana Guyana66 Zimbabwe Belize Guatemala SriLanka67 Jordan Guyana Morocco Guatemala68 Bolivia Thailand Ecuador Morocco69 Morocco Morocco Nicaragua Egypt70 Syria Swaziland Syria Jamaica71Coted’IvoireEgypt Egypt Ecuador72 Papua New Guinea Syria Indonesia Nicaragua73 Congo, Dem Rep Cameroon Sri Lanka Syria74 Honduras Zimbabwe Papua New Guinea Indonesia75 StVinc/GrenadinesHonduras Zimbabwe India76 Thailand Bolivia Honduras Honduras77 Ghana Sri Lanka China Georgia78 Cameroon Papua New Guinea Solomon Islands Bolivia79 Togo Coted’Ivoire Bolivia Lesotho80 Mauritania Solomon Islands India Papua New Guinea81 Gambia Congo, Dem Rep Pakistan Ghana82 Central African Rep Indonesia Ghana Pakistan83 Botswana Gambia Cameroon Cameroon84 SriLanka Togo Mauritania Chad85 Senegal Mauritania Lesotho Zimbabwe86 Egypt, Arab Rep Senegal Gambia Gambia87 Zambia Ghana Coted’Ivoire Sudan88 Madagascar Central African Rep Togo Mauritania89 SolomonIslands India Georgia Bangladesh90 India Rwanda Senegal SolomonIslands91 Sudan Pakistan Bangladesh Senegal92 Indonesia Bangladesh Sudan Coted’Ivoire93 Niger Zambia Nepal Togo94 Sierra Leone Sudan Central African Rep Nepal95 Chad Congo, Rep Kenya Rwanda96 Bangladesh China Congo, Dem Rep Burkina Faso97 Pakistan Sierra Leone Burkina Faso Nigeria98 Kenya Kenya Guinea-Bissau Kenya99 Rwanda Madagascar Chad Central African Rep100 Nigeria Benin Nigeria Benin101 Guinea-Bissau Lesotho Benin Congo,Rep102 Benin Nepal Madagascar Zambia103 Nepal Burkina Faso Zambia Madagascar104 Burkina Faso Niger Congo, Rep Niger105 Burundi Chad SierraLeone Guinea-Bissau106 Congo, Rep Guinea-Bissau Burundi Congo, Dem Rep107 Lesotho Burundi Niger Burundi108 China Nigeria Rwanda Malawi109Malawi Malawi Malawi SierraLeoneSource: World Development Indicators 2006, World Bank.

SPECIAL ARTICLEEconomic & Political Weekly february 2, 200855precarious situation that we were in in the early 1990s, with large short-term debt and unmanageably high debt-service ratio, rapidly abated. India’s exports picked up and the software boom was firmly on course [Murthy 2007]. Finally, let me turn to the last and most recent growth spurt that began four years ago and is continuing. Not surprisingly, since the analysts have not had time to catch up with the events, this is the least understood of India’s three growth surges. Among the chief causes of this latest surge there are four contenders that I would like to comment on. (1) The nation’s savings (and invest-ment) rate, which is the critical driver of economic growth, has seen the most astonishing rise over the last four years, from 24 per cent to 34 per cent of the nation’s GDP, after remaining virtually stagnant since the late 1970s. This places India, for the first time, a participant in what was once thought of as an exclu-sively east Asian phenomenon – the ability to save and invest over30 per cent of the national income. (2) The lastUS presidential election caused a second outsourc-ing boom helping our economy greatly. During the election there was a lot of criticism of US firms that were outsourcing back office work to developing countries, India being the major destination. This had the unexpected effect of advertising the major cost- savings possible by outsourcing. Medium to small American firms that did not know about the profits to be made by outsourcing suddenly became aware of this. Advertising on US television is very expensive and Indian firms could never have financed this on their own. The advertisement effect of the debates on television during the lastUS election and subsequent attacks on outsourcing by some conservative television commentators have turned out to be an unexpected boon – someone else paying for your publicity. (3) Though this is hard to prove since it is difficult to measure and quantify, I believe there is a major cultural and social revolu-tion on in India. For a market economy and, for that matter, any modern, industrial economy to function effectively requires a certain culture and a set of enabling social norms. The instinctive urge not to renege on contracts, the ability to restrain oneself from cheating to make small gains, having a culture of trust, and a multitude of other matters of habits and consuetude play a vital role in making a market economy possible. It is my belief that nations that have faltered on the path to industrialisation the sub-Saharan African nations, the south Asian economies, includ-ing India till recently, and many Latin American ones, have done so not because of large government (as the Chicago School would have us believe) or wrong fiscal or monetary policies as much as because the underlying structure of social norms and culture needed for an industrialised market economy were not in place. (4) Finally, there is the changing position of India in the world. For reasons that lie mostly beyond India’s borders, India finds itself today with some strategic advantages and opportunities. These opportunities are mainly in politics but they are also beginning to yield some tangible economic benefits. This is a subject that I will return to in the last section of this paper.Comment (3) above deserves some elaboration for it has important implications for often-heard counter-factual observa-tions, such as “only if India had undertaken the reforms of the early 1990s in the early 1950s, we would not have lost 40 years of growth”. We have plenty of examples of Latin American countriesthat opened early and were ravaged or, more accurately, savaged by global capital. Interacting with global corporations requires a certain amount of sophistica-tion, without which it is easy to cut so many bad deals that one is left worse off in the end. It is difficult to know what an early opening up would have done to India, but it cannot be ruled out that we would have gone the route of so many banana republics that were ruined by this. One has to read accounts of native Americans doing “voluntary business” with the settlers and losing land in scandalous deals to under-stand what an unprepared launch into completely free-market transactions can do [Banner 2005]. Even recently India cut a very poor deal for power generation with Enron. And we were saved only because Enron was ruined. Culture and the EconomyThe exact link between culture and the economy is ill-understood though a recent literature on “trust games” – games in which, if two players can trust each other, they do very well, but, if one person betrays the other’s trust, then he does even better – is beginning to give us some vital clues about the connection between social variables such as trust and integrity and economic success. A conjecture that I would like to maintain is that the success of the 1990s and other factors that we may not even be aware of are now triggering a change in vital cultural variables that is giving this third growth surge an additional vitality. It is arguable that there is something common between higher savings and greater trustworthiness. Being trustworthy means foregoing small, immediate gains (the gain that one could make by letting down an investor, for instance) and achieving a greater return in the long run, because the reputation of trustworthiness means that more business and investment will come one’s way. Hence, greater trustworthiness is a counterpart of greater savings, which amounts to foregoing some current consumption to get even more consumption in the future. The latter is financial and the former social, but they probably have the same fundamental root, a growing ability to wait, greater patience or, what we econo-mists would describe as a lower time discount rate. So my conjec-ture is that in India there is a lowering of the discount rate that is occurring. This is resulting in higher savings which we can see and is well-documented and also improving trustworthiness and the culture of business, which we cannot formally document and so must be treated, for now, as conjecture. The social and political infrastructure of business is still poor in India, as is easy to see from the World Bank’s new cross-country Table 2: Foreign Exchange ReservesYear Foreign Exchange Aggregate Export Short-Term Debt, Debt- Reserves of Goods and Services As % of Forex Service ($ Millions) ($ Millions) Reserves Ratio1977 5,824 1990 5,834 18,477 129 351994 25,186 26,855 14 261998 32,490 34,298 16 182002 75,428 52,512 10 142005 130,000 83,500 2007 (early) 199,179 126,330 Source: Economic Survey (various), Ministry of Finance, Government of India; Reserve Bank of India; and press releases of the Ministry of Commerce.

SPECIAL ARTICLEfebruary 2, 2008 Economic & Political Weekly56data on doing business in different nations, some of which are presented in Table 3. Consider starting a new enterprise. To get all the requisite clearance will take five days in the US, six days in Singapore, 48 days in China and 71 days in India. Take contract enforcement, which is vital for the effective functioning of markets. To enforce a contract takes 69 days in Singapore, 241 days in China and 425 days in India. Even if you can start a business and have contracts enforced, the real catch is in closing a business. The time taken to close an insolvent business is nine months in Singapore, two years in the US, 2.4 years in China and an epic 10 years in India. To improve these constraints requires changes in the law but also changes in institutions and the culture of governance. How the latter can be achieved is ill-understood. One reason for this is that economists treated culture and institutions dismiss-ively in the past. But clearly the links between these and the economy hold vital clues to development and deserve much greater research initiatives. It is arguable that law itself should be thought of as part of the larger idea of social and political institutions in which the economy is embedded. This has theoretical implications [Basu 2000, Chapter 5] but also places subtle burdens on our regulatory structure, especially as India becomes a more market-oriented economy [Anant and Singh 2007].To sum up, the infrastructure of norms and culture that enable enterprise and innovation and help build up an industrial society still has a long way to go in India, but my surmise is that it has begun changing. On the financial and economic side savings and investment are up and the international sector of India is doing very well. These are trends that do not change too rapidly. Savings behav-iour and culture, for instance, do not change dramatically from one day to another (unlike share prices or the rate of inflation).4 Since international performance and savings are the bulwarks of India’s recent high growth, and, to the extent that the culture of the market is changing for the better, my expectation is that India is now in for a long phase of high growth. So the growth rate of between 8 and 10 per cent per annum is, in all likelihood, here to stay for a few decades. And if this happens, a simple back-of-the envelope calculation shows that by 2030 India will have a per capita income of $ 20,000, which will place us in the category of industrialised nations. Even though a war or political instability can upset the scenario, this is not a scenario that can be dismissed out of hand.2 Inequality and Poverty: The Quintile CriterionWhere there is reason for greater apprehension and concern is in the area of poverty and inequality. In distributing the spoils of the high growth we have done singularly badly. The bulk of India’s aggregate growth is occurring through a disproportionate rise in the incomes at the upper end of the income ladder [Baner-jee and Piketty 2005; Bardhan 2007]. As a result, India’s income distribution is deteriorating; and the size of the population living below the poverty line remains embarrassingly large (even though the percentage of the population below the poverty line is declining).5 These can of course become the cause of political instability and upset the aggregate growth scenario. But even if that were not to happen – the elite in India is quite good at the art of redistributing just enough crumbs to the toiling masses to keep insurgency at bay – such inequality and poverty are morally wrong in themselves and so we need to address them urgently.To do so it is important to understand the main cause of India’s and, for that matter, the world’s large population below the poverty line. At the deepest level this is a consequence of unfet-tered capitalism with its current system of inheritance that allows those who manage to become rich once to keep their wealth for their proge-nies.6 Children are therefore born into wealth, with plenti-ful opportunities for prosper-ing and amassing even more wealth, or into poverty, with their chances, for all practical purpose, blighted at birth. The resemblance to a system of caste or apartheid is unmistakable. The fact that this system is grossly unfair does not mean it is obvious what should be done about it. When people have rushed in thoughtlessly to alter it, this has at times led to chaos and exploitation and at other times it has meant that wealth has merely changed hands, with the system intact. Jose Saramago was right when he remarked that the fall of the USSR was not the fall of socialism but of one kind of capitalism – one that the Russian “communists” had ended up creating, despite their ideal-istic initial intention. There is reason to enquire into how to change the present system, but that is too large a question for this essay, and in any case this is not likely to be resolved soon and there is a lot to be done in the interim.I wish to restrict myself here to the interim and more limited questions of what can be done now, in today’s India and given the system that we find ourselves in. Even to such more limited questions, however, the answer can take myriad forms of complexity. Two important instruments for climbing out of extreme poverty are education (or the acquisition of human capital) and health (which enables one to work hard and be productive). Even if we cannot alter the system through which some dynas-ties manage to keep large amounts of national resources to themselves and their progeny, the government can do a lot by ensuring the population gets basic education and healthcare. To the extent that this is financed by taxing the rich and from resources generated by the government, this entails some trans-fer of resources in the correct direction. Hence, India’s civil society must bring pressure on the government to undertake a certain amount of direct action, much more than it does now. In Table 3: Bureaucratic Costs, 2005 No of Time to Cost to Register No of Time to Time Closing Difficulty of Procedures Start Business Procedures Enforce a Business Firing Labour to Start Business (% of Per to Enforce Contracts (Years) Index, 0-100 Business(Days)CapitaIncome)Contract(Days)India 117162 40425 1090China 13481425241 2.4 40Hong Kong 5 11 3 16 211 1.1 0Malaysia 9 3021 31300 2.3 10US 5 5 0.5 17250 2 10Singapore 6 6 1 23 69 0.8 0Source:Doing Business 2006, World Bank, 2006.

SPECIAL ARTICLEEconomic & Political Weekly february 2, 200857these times of revenue buoyancy, the government ought to divert more funds to directly supporting the poor – by ensuring that they have access to basic food, schooling and healthcare [Dreze and Sen 2002]. That India has lower literacy rates than several poorer sub- Saharan African nations speaks volumes about our government’s neglect of the poor. That malnutrition in the masses is rife and, by some measures, rising [IIPS 2007] speaks of the same neglect. There are numerous ways in which the rich are subsidised. The richer classes, through their ubiquitous Residents Welfare Associ-ations in all major cities, often complain about vendors occupy-ing public space and say this amounts to an uncalled for subsidy to the vendors. But if we add up the areas that the wealthier residents of our cities, who are the members of Residents Welfare Associations, carve out outside their homes as parking space for their cars and have security personnel guard and shoo away people from these cemented spots, the total will, in all likelihood, be more than what the vendors occupy. If we can turn a blind eye to such sops to the rich, there is no reason to flinch at every little subsidy that goes to the poor. There is a lot on the poverty front that can be achieved through direct budgetary provisioning and one of the immediate tasks for our union and state governments is to allocate more money for this and ensure that the money is properly spent. But it is also a fact that, even after such provisioning, there will be a lot that will remain to be done; and what action can be taken beyond this is a difficult question, where politics and economics intertwine inextricably. We have seen this in the experience of West Bengal’s Left Front government. For nearly 30 years it took a tough line on industrialists – if you want to function in the state you have to pay workers good wages and offer good terms, the government insisted. This sounds unexceptionable but reflects a failure to understand realpolitik. In response to this the industrialists did not employ workers on better terms; they just did not employ workers. They left the state. What West Bengal saw over 30 years was a steady deindustrialisa-tion. Since agricultural growth cannot in the best of times match the high rates at which industry and services can grow, West Bengal lost out overall, despite its good agricultural performance. This mistake was realised four or five years ago. It was realised that one does not have to love capitalists to invite them to the state. It is a simple matter of choice. Do you have an option? For each single government, the answer in today’s globalised world is no, and it is unfortunate that West Bengal took so long to recog-nise this. The Chinese recognised this in 1978. There has been a lot of effort to make amends for this mistake, starting with the wooing of Tata’s small car project (the “ultra-affordables”) away from Uttranchal to Singur, in West Bengal.7 There is no question that today the large corporations are getting a wonderful deal playing one government against another. But equally beyond question is the fact that there is very little else that each government can do on its own. Not to attract capital is to doom your workers to poverty and unemployment. To attract capital is to contribute to growing global inequality. This is a problem that is afflicting not just poorer nations like India and China but also Organisation for Economic Cooperation and Development (OECD) nations. Thanks to inter-country competition to attract capital, there has been a steady erosion of the corporate tax rate inOECD countries. Inequality has been growing in China, India and the US, but also in the bastions of equality like Japan and the Scandinavian nations. This is a consequence of globalisation.How do we think about policymaking in such a world? I want to discuss some analytical tools for answering this question. At the root of the policy dilemma is the fact of a trade-off between inequality and poverty.8 In some contexts, a government is compelled to choose between greater inequality and greater poverty. In a poor nation when one faces such a choice, I believe one has to choose less poverty. So there are situations where one may have to live with a greater inequality to achieve not higher growth (I would consider that an unacceptable trade off) but less poverty. The reason I place the qualifiers “in some contexts” and “there are situations” in italics is to emphasise that this claim must not be reduced to a licence for tolerating any inequality. People often say that, though over the last two decades India’s inequality has risen a lot, poverty has declined, so that is fine. This is not what I am claiming, since there is no reason to believe that the lower poverty was made possible by the greater inequality. To handle this policy quandary in a practical way, I would suggest a simple welfare criterion. We should judge a nation’s performance by the condition of the nation’s poorest 20 per cent people. So instead of looking at the per capita income of the entire population of each nation and making inter-country comparisons (as most international organisations do), we should look at each nation’s per capita income of the bottom 20 per cent of the population – I have elsewhere called this the “quintile income” – of the nation, and compare these values [Basu 2006; Subramanian 2006, 2007]. This entails a practical, policy-oriented formulation of John Rawls’ famous criterion of focusing on the primary goods consumption of the poorest person in society. The quintile principle that I am suggesting here has several attractive features. It does not mean that one totally ignores the rich. If one did so and just tried to enhance the welfare of the poorest people, then the poorest people after some time would cease to be the poorest people. Some of the previously rich would now fall into this category, replacing some of the previously poor. But since by the quintile principle the focus is always on the bottom quintile of society, focus would now automatically shift to the previously richer person who would now be overtaken by the previously rich. Second, the quintile principle does not ignore growth, but its focus is on the growth of income of the bottom quintile of society. Basing policy on the quintile criterion leads some interesting insights into how to handle trade-offs between poverty and inequality and the special dilemmas that globalisation give rise to. This is the subject matter of the next section. 3 Globalisation, Poverty and InequalityThis section develops a simple, highly-stylised model to illustrate some of the principles discussed thus far. In particular, the model will illustrate (1) how the “quintile axiom” may imply that we

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SPECIAL ARTICLEEconomic & Political Weekly february 2, 200859removal. A more troubling trade off, and one that is poorly under-stood, is that between poverty eradication and controlling inequality. The model just constructed shows how such trade-offs can occur. I would take the view that, in poor countries, the priority should be on the betterment of the poor. So I would take the view that in a situation like the one just described, the inequality that occurs attQ is worthwhile tolerat-ing, because this is the inequality needed not to maximise growth but to maximise the well-being of the poorest sections. This is the idea of tolerable inequality discussed above. It is worth clarifying that it is not always the case that the poverty minimising tax will be less than the inequality minimis-ing tax, as shown in the figure. If this does not happen, then of course there is no quandary between poverty minimisation and inequality minimisation. So all that is being suggested here is that there are possible scenarios where a nation faces a trade-off between inequality and poverty; and it is my belief that these scenarios are realistic and widespread.The shrinkage of policy space that occurs with globalisation and how globalisation may contribute to greater inequalityand greater poverty can now be illustrated using the above model. To see this, suppose that workers can choose to migrate from one nation to another and they choose to go where they have the highest income. I shall also assume that when a worker decides to migrate she needs permission (a work permit or visa) from the host nation before she actually manages to migrate. It will be assumed that, if all countries have the same tax/subsidy rates, then each person stays in his or her home country. That is, when indifferent between migrating or not, a worker prefers not to migrate.In reality, with globalisation, movement between nations can occur for not just labour but corporations, goods and services. But, since this is a very simple model with only just one factor of production, to wit, labour, I assume that this is the only factor or agent that can migrate. The instrument that governments have for attracting skilled labor is the tax rate. So what I am considering is, effectively, a model of “real tax competition” [Atkinson 1999]. The problems of domestic policy in the event of globalisation of the kind just described can be illustrated in many different ways. Let me here consider the case where each country aims to maximise its quintile income. In other words, each country has a government that is genuinely concerned with raising the stand-ard of living of its poorest citizens. If the boundaries of nations were exogenously closed (that is, no labour movement was allowed), each nation would set t = tQ, as shown in Figure 2. Now, let globalisation remove the exogenous hindrance to labour movements. Note that each country setting t = tQis no longer an equilibrium. Suppose one country lowerst, clearly all productive people from other nations will want to migrate to this country. If the government now decides that it will (1) allow some of the rich people to come in and (2) not allow any poor person to come, it will clearly be able to increase the income subsidy-per capita that it gives to its poorest citizens. And for this reason it will be in each national government’s interest to cut tax rates a little. SotQ cannot prevail in equilibrium. To use the language of game theory, every government setting the tax rate at tQ is not a Nash equilibrium.From the above analysis it should be evident that there is no tax ratet greater than 0 that will prevail in equilibrium. Because if all other nation’s are charging t, a government can lower tax a little, attract the rich and use the tax collection to subsidise the poor citizens of the nation. Hence, in equilibrium every country will sett = 0. Real tax competition in a globalised world results in the erosion of taxation; and in equilibrium we will have all rich and poor people earning as if there is no government. Each country ends up behavingas if it were interested in maximising national income with no concern for poverty or equity. Globalisa-tion erodes each national government’s power to have equity-conscious policy. The mobility of labour (and, in a more realistic model, the mobility of capital) compromises a nation’s policy efficacy.International CoordinationWhat the above analysis demonstrates is the need for inter-national coordination of anti-poverty policies. This is not to deny that redistributive policies and more aggressive anti-poverty policies by individual governments are possible; and one must not let governments off the hook in terms of this part of its responsibility. But, at the same time, it has to be recognised that, as globalisation progresses, there is increasing need for the coordination of policies across nations. What is “correct” policy for a nation may depend critically on whether other nations are also adopting a similar policy. As the above model shows, if one cannot coordinate with other nations on tax policy, it is in the best interest of the nation’s poor that the tax rate be kept low (tU, in the model). If one can achieve a coordinated tax policy, one should raise the tax higher (to tQ, in the model). The italicised qualification above is important. This is what makes the result somewhat paradoxical. That tax rates would be kept low if one cared only about the nation’s rich is obvious enough. It is the focus on the bottom quintile that makes this interesting.The same issues play out at an interstate level. The recent pronouncement by prominent members of West Bengal’s commu-nist-led government (aimed mainly at its cadre base) that social-ism is not feasible at this stage in the states ruled by the Left Front and so they have to run on lines of capitalism, because the bulk of the nation is capitalist and an attempt at a more redistributive policy in a few regions will cause flight of capital and jobs, is a valid observation. The only corollary one would add is to point out the same would be true even if the Left Front came to power all over India. Its policies would have to be much the same since, in today’s globalised world, capital and jobs move not just across states and districts but national boundaries. If there is to be a major policy shift the need is for global coordination. When we see the enormous poverty in Ethiopia or Tanzania, we tend to blame it on its government. While most governments have room to improve their performance, it would be wrong to overlook that how much control Ethiopia has over Ethiopian poverty or Tanzania has over Tanzanian poverty depends in part on what happens in Kenya, India, China and the US, on the trading rules that apply between nations, the facilities that are

SPECIAL ARTICLEfebruary 2, 2008 Economic & Political Weekly60there for the movement of foreign direct investment and the nature of global institutions. As discussed above, one sees this played out within India, with large industrial houses increasingly mobile between regions and states and with state and local governments having been granted greater autonomy of policy. But my point is that this greater legislative autonomy may well be compromised in effect by the limitations in policy space that occur through the increasing mobility of labour and capital that may happen naturally as technology makes travel, relocation and communication less onerous. Hence, if we are to tackle the problem of inequality within each nation properly (even leaving aside the problem of interna-tional inequality), we need to have international coordination. Unfortunately, there are no institutional channels for this as of now. For coordinating problems of labour rights and standards there is the International Labour Organisation, for the coordina-tion of trade policy issues we have the World Trade Organisation, but there is nothing for anti-poverty and inequality mitigation. It is true that certainUN organisations are engaged in policies for poverty removal but what is being recommended here is not just setting targets such as the millennium development goals (MDGs) but a mechanism for coordinating policies. It is beyond the capacity of this paper to go into the institutional and organisa-tional details of how this can be achieved. The aim is simply to explain the analytics of the problem and to stress the need for international action. 4 A Comment on Foreign PolicyI have saved the unsavoury for the last. The world of foreign policy is murky in the best of times. For India this is a time of change and difficult choices, a time when the nation finds itself at the cross roads with paths that can set it off into uncharted territories, where there can be a lot to gain but also the risk of losing a great deal. As mentioned above, there is a connection between India’s recent economic performance and oppor-tunities, and the strategic space that it, for reasons beyond its control, has come to occupy in the world, especially vis-à-vis the US and China. Hence, our foreign policy and domestic economics are probably more intertwined today than at any time in the past.The growth of the Indian economy is important to the US and other industrialised nations for the demands that this creates for goods and services and, in particular, defence products. For the industrialised military powers and, in particular, for the export-ers of weaponry and defence-related material (“defence” in these situations, in case the reader needs to be reminded, is a euphe-mism for “defence and offence”), the ideal situation in Asia is a build-up towards war but no war. A war is too destabilising for the whole world; so not desirable. But a build-up towards war means more profits for the defence industries. Apart from this narrow economic interest, for the US, India is the only realistic counterpoise to China in the long run. As China rises to global prominence there is concern that matters which are relatively dormant currently, such as the global position of Taiwan or the status of North Korea, will come to the fore. There is worry, for instance, that, if China establishes full control over the Straits of Malacca, it will have its hands on a vital artery of world trade. The encouragement given to India by the US to conduct naval exercises in the Straits of Malacca is to keep the region from slipping into solely China’s charge [Basu 2006a].Likewise, Indian takeover of western firms and corporations have not met with as much political opposition as China’s attempted takeovers. China National Offshore Oil Corporation’s (CNOOC) move to buy some American firms and the attempt by China’s major producer of household appliances, Haier, to take over Maytag in the US resulted in a kind of concern that goes beyond the purely commercial and reflects this general worry about China’s rise and potential political dominance. The worry is accentuated by the fact these mega Chinese companies are largely state-owned. 70 per cent ofCNOOC’s shares are owned by the government of China. Haier is technically called a “collective company” and is supposed to be owned by the workers but in effect it is controlled by the state. Hence, the entry of these corporations in theUS is often viewed as conduits for the entry of the Chinese government.These essentially political matters have had spillovers for the Indian economy. About half of all H1-B visas that the US gives out (these are visas for engineers, scientists and other professionals) go to Indians;13 about 70 per cent of India’s software exports end up in theUS [Murthy 2007]. The big market for India’s pharma-ceutical industries is North America [Chaudhuri 2005]. These are not matters on which the US takes an unambiguous stand since China is a major trading partner of the US, much more important than India. Hence America’s business and political communities often have differences of opinion on what consti-tutes “American interest”. But, with their focus on the long-run, the recent influential neoconservative writings in theUS have made frequent reference to the need for the “containment of China”. And it is now widely recognised that, since 2002, the US has been viewing India as an important pole in a future multi-polar world and, as such, a safeguard against the risk of the world becoming bipolar, with theUS witnessing a face-off with China in a playback of the cold war days. These changes are viewed in India as presenting the nation with a serious dilemma – whether to retain its commitment to the policy of non-alignment, which India has adhered to with consid-erable diligence through the years, or to collaborate with the US on vital matters such as nuclear energy, defence, trade and invest-ment. The fear, often expressed, is that to enter into these kinds of collaborations will amount to India giving up its independent foreign policy positions and falling totally into the ambit of western nations. In an elegant and skilfully-argued essay Chenoy and Chenoy (2007) have analysed the recent shift in Indo-Ameri-can relations, its implications for our economy and the risky foreign policy options that India is faced with today as a conse-quence of it. They end up cautioning India against these new interactions, be it in matters of foreign policy, foreign direct investment or the pending nuclear deal, “Agreement 123”. This isa paper where I find myself in agreement with most of the analysis but not with the conclusion. This needs explanation.The source of the disagreement is an implicit belief which underlies the analysis of Chenoy and Chenoy and with which I

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